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Thursday, 20 October 2016

A note on "Economic Activity"

An aim of government deficit spending is typically
to increase economic activity, of which "maximising" employment plays an integral
part. This is also supposedly the aim of monetary policies, especially during
periods of slow GDP growth. [1]

But what is actually meant by increased economic activity? [2] Is
it an increase in GDP? Is it synonymous with economic growth? The distinction between the two is necessarily a blurry
one, and one regularly used interchangeably (e.g. see footnote 2). But the distinction is an
important one and one that ought to be defined to avoid confusion and minimise abuse. If by increased economic activity
we are to understand any increase in
production, employment, investment, trade or consumption, then policies
promoting such developments will probably succeed. Creating any activity to keep people busy is
rather easy when it can be financed with deficit spending supported by
regulations facilitating the accumulation of government debt. [3] The
problem of course is that such policies rarely discriminate between productive and unproductive activity. For example, the purpose of government deficit
spending (besides financing wars) once was to compensate for an economic
slowdown in the private sector. The running of fiscal deficits was meant as an
intermediate measure to shorten a recession [4]
and spur economic growth. The idea being that this “stimulus” would bring about
private sector surpluses to fill the deficit gap. This promise has never been
fulfilled, especially in recent years. Instead, the results have been
unequivocally poor with respect to the accumulation of further debt; most
western countries, and many others, have accumulated more government debt than
can ever be repaid with any reasonable or remotely palatable taxation policy. [5]
Going deeper into debt to reduce debt has predictably culminated in yet more
debt. In the U.S., economic policies have led to not only substantial increases
in debt, but have, more importantly for the point in hand, led to a decline in
personal income relative to debt.

As less debt and higher
personal income is clearly desirable to more debt and less income, any
reasonable taxpayer and government official, given the choice, would prefer a
higher personal income to government debt ratio rather than a lower one. As the
chart above shows, this ratio in the U.S. is now at the lowest level ever
reported for the last 50 years. Since the ratio peaked in 1981, debt has increased
1,842 percent in total (ca 6.1% p.a.) while personal income has greatly lagged
and only expanded 651 percent (ca 4.1% p.a.).

Despite the fact that it fails to
spur economic growth, [6] deficit
spending continues to be the norm, rather than a counter-cyclical economic
policy. Why? For one because it just might help increase economic activity over the short- to medium term.But perhaps of greater significance, it
is a “tool” for politicians to actually do something tangible in an attempt to alleviate
the hardship that defines the recession while, at the same time, providing
“proof” to the electorate that something is actually “being done” instead of
idly sitting by doing nothing. [7] It
would hardly come as a surprise if most politicians acknowledged the challenge
of being reelected if they document that no actions were taken while in office.
Such interventions don't help economic growth however, neither over the short-
nor the long term. And that’s why it’s so important to distinguish between economic
policies promoting any activity and those
contributing specifically to economic growth; the distinction between activity
and growth necessarily becomes a blurry one as the former doesn’t discriminate
between productive and unproductive activity, i.e. it may refer to any economic activity and not
necessarily economic growth. Economic activity can therefore be increased
rather effortlessly through increased government spending financed with debt.
The recipients spend (a part of) the money received, which again are spent by
the next recipient and so forth. Policies promoting economic growth on the
other hand appear much more difficult to implement, not least because it
requires fiscal discipline. A suggestion would therefore be to limit the meaning
of the word activity to refer to any
economic activity other than those actually
promoting economic growth. At least, that’s what we’ll do in this book from
hereon. The results of economic policies, especially during the last decade, can only
help to justify this distinction.

The promoters of increased
economic activity fail to see, or perhaps ignore because they’re the
benefactors, the general fallacy more often than not underpinning their
policies, not to mention their consequences; the fallacy of overlooking secondary consequences. [8]
Firstly, if the actions triggered by the policies truly helped the economy, why
hadn’t individuals and companies pursued these avenues in the first place?
Presumably the answer is a lack of savings, capital, profit opportunities, or
regulatory burdens. For economic policies to be effective, that is, promote
economic growth, they must address the fundamental problems hampering economic
growth instead of attempting to fix the symptoms (e.g. “lack”
of consumer demand) created by it. On the other hand, “uncertainty” (or a “lack
of confidence”), a regular complaint for lackluster business conditions and low
or declining financial asset prices, is only truly problematic if it’s created
by government itself. [9]Uncertainty,
an inherent feature of life in general and not just in the world of business
and investing, is regularly viewed as a negative only. However, uncertainty
acts as an effective deterrent to the (indiscriminate) wasting of resources, a
quality frequently not only disregarded, but often discarded altogether.The solution to this
problem should be obvious; undo the (expected) policies that create the
uncertainty. Secondly, deficit spending aiming to spur economic activity, often
as a means to compensate for an alleged shortfall in aggregate demand, comes at
a grave cost: the consumption of resources market participants could have
employed (more) profitably elsewhere (if not immediately, then at least in due
course) for producing what people truly want. Simply put, government
intervention focused on increased economic activity
today comes at the expense of savings and investments and, as a consequence, hampers
future economic growth. [10]

The
only “stimulus” increases in economic activity can ever hope to achieve is
therefore an increase in consumption at the expense of a decrease in savings;
the illusion of economic growth. In short, deficit spending encourages increased
spending and the depletion of savings to “keep the economy going” over the
short term. This outcome is the exactly opposite of that required for economic
growth. In summary, increased economic activity today is achieved at the
expense of lower economic growth starting the very same day.

[1]Here’s a recent excerpt from the
Federal Reserve (emphasis added): “In
the short run, monetary policy influences inflation and the economy-wide demand
for goods and services--and, therefore, the demand for the employees who
produce those goods and services--primarily through its influence on the
financial conditions facing households and firms. During normal times, the
Federal Reserve has primarily influenced overall financial conditions by
adjusting the federal funds rate--the rate that banks charge each other for
short-term loans. Movements in the federal funds rate are passed on to other
short-term interest rates that influence borrowing costs for firms and
households. Movements in short-term interest rates also influence long-term
interest rates--such as corporate bond rates and residential mortgage
rates--because those rates reflect, among other factors, the current and
expected future values of short-term rates. In addition, shifts in long-term
interest rates affect other asset prices, most notably equity prices and the
foreign exchange value of the dollar. For example, all else being equal, lower
interest rates tend to raise equity prices as investors discount the future
cash flows associated with equity investments at a lower rate. In turn, these changes in financial
conditions affect economic activity. For example, when short- and long-term
interest rates go down, it becomes cheaper to borrow, so households are more
willing to buy goods and services and firms are in a better position to
purchase items to expand their businesses, such as property and equipment.
Firms respond to these increases in total (household and business) spending by
hiring more workers and boosting production. As a result of these factors,
household wealth increases, which spurs even more spending. These linkages
from monetary policy to production and employment don't show up immediately and
are influenced by a range of factors, which makes it difficult to gauge
precisely the effect of monetary policy on the economy.” (Board of Governors of the
Federal Reserve System, 2015).

[2] According to the online Merriam-Webster dictionary, activity is
defined as “the state of being active”, where active involves action or
participation.

[3] Financial companies such as banks and insurance companies are
required by government to hold a large proportion of their financial assets in
government bonds. Financing deficits through the issuance of bonds is therefore
considerably less challenging than financing deficits through an increase in
taxation.

[4] Writes Keynes: “…a decline in income due to a decline in the level of employment, if it
goes far, may even cause consumption to exceed income not only by some
individuals and institutions using up the financial reserves which they have
accumulated in better times, but also by the Government, which will be liable,
willingly or unwillingly, to run into a budgetary deficit or will provide
unemployment relief, for example, out of borrowed money. Thus, when employment falls
to a low level, aggregate consumption will decline by a smaller amount than
that by which real income has declined, by reason both of the habitual
behaviour of individuals and also of the probable policy of governments; which
is the explanation why a new position of equilibrium can usually be reached
within a modest range of fluctuation. Otherwise a fall in employment and
income, once started, might proceed to extreme lengths” (Keynes, 1935, p. 44).

[5] E.g., as of
Q2 2016, total public debt as a percent of GDP was 105% in the U.S. and 92% in
the euro area.

[6] A range of other interventions also contribute to this outcome,
including the elasticity of money, bail-outs of banks, and increased
intervention.

[7] This is arguably a key reason why what became known as Keynesian
economics won over the “hands-off, do nothing” approach advocated by free
market economists (e.g. Mises). – this was especially the case since the great
depression and until the 1970s when stagflation proved Keynesians wrong.
Following especially the U.S. banking crises starting around 2006, deficit
spending is back in vogue and at levels not seen since WWII.

[8] Writes Hazlitt in his book analysing economic fallacies: “In
addition to these endless pleadings of self-interest, there is a second main
factor that spawns new economic fallacies every day. This is the persistent
tendency of men to see only the immediate effects of a given policy, or its
effects only on a special group, and to neglect to inquire what the long-run
effects of that policy will be not only on that special group but on all
groups. It is the fallacy of overlooking secondary consequences” (Hazlitt, 1952).

[9] Barring the threat of war by some rogue nation unprovoked by the
domestic government, the possible or probable threat of a natural disaster such
as a forecasted earthquake, or meteor expected to hit earth, and so forth. Either
way, the uncertainty created by the fore mentioned threats is not removed by
increased deficit spending and the promotion of economic activity. Such
economic policies might conceal them, but at a cost which likely will only
serve to create greater uncertainty in the future.

[10]Even Keynes recognized this
when he wrote about one particular kind of government intervention:
“Unemployment relief financed by borrowing is best regarded as negative saving” (Keynes, 1935, p. 49).